This essay examines the key characteristics of Transaction Cost Economic (TCE), and also analyses' the role played by co-ordination in a vertical chain using the issue tree, in Figure 3.4 page 131 Besanko (2007).
The design of this essay is as follows: The first section reviews the assumptions and analyses' the key characteristics of TCE. The second part discusses the role co-ordination in a vertical chain. The final section ends the essay with a conclusion.
THE KEY CHARACTERISTICS OF TRANSACTION COST.
Bryan (2004) states that typically economist defines transaction cost as search, bargaining, monitoring, enforcement and other cost not directly related to production of goods and services. The principle of TCE is used by managers in determining the make-or-buy decision of goods and services required in a production process. The assumptions of TCE as stated by Willamson (1973) bounder rationality which refers to the rate and storage limits on the capacities of individuals to retrieve store and process information without error and Opportunism is an effort to realize individual gain through lack of candor or honesty, which common forms is the asymmetrically distributed information by (at least some individuals) to their advantage. i.e people may not be entirely honest and truthful about their intentions , or they might attempt to take advantage of unforeseen circumstances which may give them an opportunity to exploit another party
The key characteristics of Transaction Cost Economics would be discussed as relationship specific assets, and the fundamental transformation concept of hold-up, rent and quasi-rent.
Relationship specific assets are a set of assets or investments made to support a given transaction specifically for the improvement of efficiency of the given transaction which cannot be redeployed to another transaction without incurring cost or affecting the productivity of the asset. For example the Akute power project which is a 12.15 Megawatts captive power plant and a 10 kilometre gas pipeline to be constructed by Oando Gas and Power limited for Lagos State water operator/ corporation in Nigeria, whereby generating electricity specifically for the water operator in order for the operator not rely on the unreliable public electricity supply and improving the water operators' efficiency (http://www.oandoplc.com/nigeria/gas-and-power/services/). A bilateral (or at least quasi-bilateral) exchange relationship for a considerable period of time once the investment has been made (Williamson 1981). Besanko (2007) described the relationship specific asset usually takes four forms; they are:
1. Site specificity : These are the investments in assets located side-by -side to take advantage of processing efficiency while economizing transportation and inventory cost. Willamson (1981:555) puts this as when successive stations are located in check -by-jowl relation to each other so as to economize on inventory and transportation expenses. As in the example above of Akute Power Project
2. Physical Asset Specificity: Assets specifically tailored to a particular transaction in both engineering and physical properties. Willamson (1981:555) gives an example of where specialized dies are required in a component.
3. Dedicated Assets: an investment in which may not be necessarily profitable, in plant and equipment induced by a promise or contract of a buyer.
4. Human Asset Specificity: a set of skills, know-how and information acquired by workers or a group of workers which are more valuable inside a particular transaction relationship than outside of it. Willamson (1981:555) as stated, that this can occur by learning, by doing.
Besanko (2007:127-129) brings the associated concepts of fundamental transformation of assets specific relationship as rent, quasi-rent and holdup problems. Rent is the profit an investor expects to make form an asset specific relationship while quasi rent is the profit an investor in an asset specific expects for using the asset if he has to turn to the next best alternative.
The holdup problem occurs by attempting to renegotiate the terms of deal after an investments in an asset specific has been completed. This can occur when contracts are incomplete thereby permitting breach and when the deal generates quasi-rent for a trading partner. The uncertainty nature is important because of the difficult to foresee all the eventualities that may occur during the course of a transaction. The frequency and the length of time which the transaction takes place will play a key role in the determination of uncertainty, Transaction in the spot market (low frequency) will have relatively little uncertainty, on the other hand when a transaction that requires some commitment over a period of time the uncertainty sets in, because we cannot predict the future. Uncertainty causes problems in part because of bounded rationality, and opportunism.
The holdup problem tends to cause an increment in the cost of arm's length market transactions in the following ways; contracts: the negation and renegotiation of contracts that bind the relationship, the contracts negotiations are likely to be time consuming and costly as each party tries to protect themselves from the possibility of holdup, also as circumstances change in unanticipated ways, the likelihood of renegotiation of contracts to prevent a situation of being held-up in future. The ability to write a complete contract that protects all parties reduces as the complexity transaction Increases. Distrust by any or all of the parties may also increase the length of contract negations by trying to provide formal safeguards, it may also impede the sharing of information to improve efficiency or improve quality. Also the possibility of holdup may also lead parties to make investment that is meant to improve their post contractual bargaining position, these could have a second source for an input to reduce risk by a sole supplier or a producer which may acquire a standby production facility for key input as a hedge against contractual holdup by the input supplier. The possibility of holdup may also reduce the incentives to invest or result in underinvestment in specific asset.
THE VERTICAL BOUNDARIES OF A FIRM AND THE ROLE OF COORDINATION.
In general, goods flow along a vertical chain from the raw materials and component parts to manufacturing through distribution and retailing. Coase (1937 cited in Jacobides, 2005) was the first to observe that, in deciding on firm boundaries, entrepreneurs and managers weighed up the benefits of internal production against the costs and risks of using markets.
For example the oil and gas industry ,the petroleum products vertical chain is from the raw material which is crude oil being explored and produced , then stored and/or transportation through pipelines and vessel to a refineries where it its processed to various other products such as petrol ,Aviation fuel , Diesel and other associated products , the refined products is later stored and distributed to various channels where they are now retailed .
Regardless of a firms' position along the vertical chain, it has to define boundaries, a firm as a pool of knowledge, abilities and experience, and will undertake stages in which it can apply existing capabilities . To resolve the associated make -or-buy decisions the firm must compare the benefits and cost using the market as opposed to performing such activities in house .(Besanko 2007:109), the firm uses the market primarily because the market firm are often more efficient by exploiting the economics of scale and learning curve and also eliminate bureaucracy(Besanko 2007:113) , and A firm vertically integrates or makes when it links products in adjacent stages within the value chain and internalize exchanges that otherwise take place in open market( Diez-Vial, 1992 cited in Diez-Vial, 2009) . Besanko (2007:118) states the cost associated in using the market and reasons for the firm to vertical integrate as the cost of poor coordination between the steps in the vertical chain, Transaction cost and asymmetric information. The role of coordination in the vertical chain will be discussed in this essay.
Coordination is defined as managing the dependencies between business activities (Malone, 1994 cited in Riemer ) and thereby making it a core aspect of using the market within the vertical chain. Coordination implies that a set of two or more actors who performs economic exchanges or activities in other to achieve goals within the vertical chain. A firm either uses contracts or merchant coordinators or independent firm that specialize in linking suppliers ,manufactures and retailers, (Besanko 2007:121), for example in the oil and gas industry , oil trading firms are specialized in linking the upstream and downstream sectors , for instance pulling up at a usual Tesco Petrol station in Manchester to fill up a car with petrol , the crude oil which is the raw material might have been explored in Nigeria , refined in Italy and retailed in Manchester, the oil traders are specialized in linking the producers of the crude to the refineries and also the refineries to the distribution networks before they are retailed .
Using the issue tree in Figure 3.4 pp131 Besanko as guide for the critical role played by coordination in the vertical chain and a firms' make or buy decision in the oil and gas industry which I am familiar with, will be used as a case study, the issue tree sets out series of questions as a guide with three outcomes or possibilities which are, using the market firm, vertically integrate or Alliance, joint ventures or other close- knit non-ownership arrangements,
Coordination arises in using the market and the issue tree would be followed in using the market. The initial questions to be asked is on the existence of market firms with economics of scale and execution capabilities that an in-house unit cannot attain, if it is analysed as no, it is followed by an analysis if an intermediary arrangement will suffice, this has two possible outcomes which are to vertically integrate or to create alliances, JV's etc if they do. Back to the initial question in the issue tree on a competent market firm, where the answer is yes the next set of enquiries are on the asset specificity, coordination and leakage of information if all these don't create a problem that detailed contracting and common ownership can't mitigate or resolve then the firm is too vertically but if it doesn't create a problem and where it does detailed contracting and common ownership mitigates the problem then the firm should use the market firm.
A petrol service retailer and Greenergy being the market firm would be used as an example of the critical role played coordination illustrating the issue tree, Greenergy exist as a market firm which exists with economics of scale by supplying to other retailers like Tesco and Sainsbury's and posses execution capabilities that an in-house unit may or would not possess, Greenergy presently supplies over 6 billion litres of petroleum products per annum. The petroleum retail industry requires relationship specific assets apart from the retail outlets it also requires storage tanks and distribution and logistics networks which require high level of coordination to ensure product availability, and the petroleum retail industry is those not have the nature of information leakage as the information is widely available in the public domain, Greenergy has seven storage facilities in the United Kingdom and its reliability indicators published in January 2010 shows that its haulage delivery performance between July 2009 to January 2010 98.97 % on schedule , and Product availability at over 99% in January 2010 and also 99.06% accuracy in invoicing between January and December 2009 (http://www.greenergy.com/customer_service_levels/reliability_indicators.html). This is an indication that a market firm like Greenergy could be used in the retail petroleum business in the United Kingdom to source and deliver to retail outlets. The issue tree further provides for detailed contracting and common ownership to militate against contracting problems (as Tesco has done with by acquiring 25% stakes in Greenergy http://www.biofuelwatch.org.uk/docs/greenergy_factsheet_2.pdf before considering vertical integration.
This essay has identified the Key characteristics of TCE as relation asset specific and the assumptions of bounder rationality and opportunism, fundamental the transformation concepts of Hold-up, Rent and Qusai-Rent. The second part discusses the vertical chain and the critical role played by coordination.